Blind Authority and Asymmetric Information

Mercenary Trader

Feb. 18, 2014, 3:37 PM

"In 1967, George Akerlof, a first-year economics professor at the University of California, Berkeley, wrote a thirteen-page paper that used economic theory and a handful of equations to examine a corner of the commercial world where few economists had dared to tread: the used-car market. The first two academic journals where young Akerlof submitted his paper rejected it because they "did not publish papers on topics of such triviality." The third journal also turned down Akerlof's study, but on different grounds. Its reviewers didn't say his analysis was trivial; they said it was mistaken. Finally, two years after he'd completed the paper, The Quarterly Journal of Economics accepted it and in 1970 published "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism." Akerlof's article went on to become one of the most cited economics papers of the last fifty years. In 2001, it earned him a Nobel prize."

"In the paper, Akerlof identified a weakness in traditional economic reasoning. Most analyses in economics began by assuming that the parties to any transaction were fully informed actors making rational decisions in their own self-interest. The burgeoning field of behavioral economics has since called into question the second part of that assumption - that we're all making rational decisions in our own self-interest. Akerlof took aim at the first part - that we're fully informed."

- Dan Pink, "To Sell is Human"

JS Comment:

There is an old joke about two economists walking down the street. One of them sees a $20 bill lying in the gutter. "Look," he says, "Twenty bucks."

"That's impossible," says the other. "If it were real, someone would have already picked it up."

Economic theory assumes perfect (or near-perfect) information distribution, followed up by perfectly logical decision making. But this is patently ridiculous… even in the world of economics itself. Consider the case of Akerlof's 1967 paper. Given that this paper went on to earn a Nobel and become one of the most cited works in half a century, it was undoubtedly high quality stuff - the equivalent of a million-dollar-bill in terms of economics research. And yet the first journal called it "trivial," the second called it wrong, and it took two years to actually get "picked up".

Talk about an inefficient market! Yet this kind of thing happens constantly. Think of Steve Ballmer, the ex-CEO of Microsoft, declaring the iPhone would have "no chance." Or the music executive who turned down the Beatles because guitar music was "on the way out." Or the dozens of publishers who turned down the Harry Potter series. Or on a more basic level, the opportunity-dismissive decisions made by authority figures every single day in business, government and life.

The "blind authority" phenomenon is a routine occurrence. Sometimes that twenty-dollar-bill (or much larger denomination) that you see waiting to be picked up is real, because either 1) you are early enough to the scene or 2) the opportunity is large enough that you aren't too late to capitalize on it, along with a minority of others who saw it in time too. To deny this reality is foolhardy. Economists and efficient market theorists just make the denial worse by ramping up the arrogance: "Not only are we blind, and not only are YOU blind too, so is everyone else!" Except, presumably, the mythical guy who picked up the twenty bucks the instant it got dropped. (The markets are so efficient that nobody can make money… except the mythical beings who make it efficient in the first place. Huh?)

Akerlof made big strides in economic theory by pointing out the impact of asymmetric information. His example was used cars, classifying them as "peaches" (a car that runs well) and "lemons" (a car that will break down). If a buyer has no way of knowing whether he is getting a peach or a lemon, his willingness to transact will decline. Asymmetric information, in this sense, harms liquidity and has a negative impact on the marketplace. (This is one reason a functioning marketplace needs well enforced accounting rules. If half of all earnings reports were fraudulent, people wouldn't trust earnings at all anymore, and just wouldn't invest.)

But as far as trading opportunity goes, there is another, even more important asymmetry that economists don't talk about. That is the difference in how information is used and interpreted. Not everyone gets the same information. Some get bad information, and some fail to do their homework. But even if everyone did get the same information, an imbalance in quality of analysis and action - an asymmetry in what was done with the information - would result in the potential to outperform.

Great traders know this instinctively. Put a great trader and a lousy trader in a room. Give them the exact same information. Wait long enough and what happens: The great trader makes money. The lousy trader doesn't (or not nearly as much). Why? Asymmetric interpretation and use of the information received.

The sheer obviousness of the point, once made clearly, might make you feel disgusted at how backwards and obtuse academia can be (in regard to basic market theory). Join the club!

JS (jack@mercenarytrader.com)

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